It
is nonetheless a serious defect of our present fractional reserve system that it
requires continuous jiggling of monetary tools...
...recommending that the present system be replaced by one in which 100%
reserves are required.
I urge that interest be paid on the 100% reserves.Milton
Friedman, 1976 Nobel Prize laureate (from his 1959
book, Ch. 3)

The
truly urgent problem, I think, is the abuse of deposit insurance.
"One-stop" banking and financial servicing is a popular slogan, but it tends to
fall apart under close scrutiny.
Collecting various services under one roof will not make your visit "one-stop"
except for parking your car.
"One-statement" finance is probably another mirage.
Companies owning banks must be prevented from placing the risks of their various
activities on those safety nets.James Tobin,
1981 Nobel Prize laureate (from a 1987 article)

A brief overview of this
proposal

What is "narrow banking?"

The
narrow banking
proposal calls for a total separation of bank deposit accounts from all
other bank
activities to address the following issues:

During the years
leading to financial crises, banks lend around
90% of the money deposited in transaction accounts (such as checking) and
over 95% of total deposits (savings accounts included).

Banks are not
required to obtain permission from depositors to lend and take risks with
their money.

Under this
proposal, banks would be able to lend using depositors' money only after
the depositors themselves choose to transfer their money to designated "lending" accounts that will be regarded
as "risky" accounts (similar to mutual funds).

Otherwise,
depositors' money will be kept as liquid cash or deposited with the central
bank.

Reducing the
implicit subsidies (rescue guarantees) provided to commercial banks by the taxpayer
and central banks.

But, why should I care? My
bank is FDIC insured!

Not so fast, as it turns
out, your "insurance" company does not have a lot of money. The Federal Deposit
Insurance Corporation (FDIC)
reports
that its deposit insurance fund has $72.6 billion, which constitutes a
reserve ratio of 1.11% out of total deposits. This means that the FDIC fund
can recover less than 2% of total deposits during bank failures. To obtain a rough
estimate for why the FDIC becomes almost irrelevant during financial
crises, each of the three-largest U.S. banks ranked by total deposits holds over $1.2
trillion ($1,200 billions) worth of deposits. More precisely, the
amount of deposits held by each of the 24 largest banks in the U.S. is larger than
the entire FDIC fund.

Another common misperception
related to the "safety" of bank deposits stems from the fact that depositors are not
aware that they are not first priority in bank liquidations regardless
of how much money they deposited. Bankruptcy liquidation priorities are discussed in
Marino and Bennett (1999).

But, central banks argue
that banks are "safe" now

What central banks
attempt to do is to raise banks'
capital requirement to 18%. What's odd about this is that central
banks and even academia ignore the simple fact that major banks that
failed in the 1930s held over 20% equity on their balance sheets, see
Foroohar (2016, p.33). The evidence
provided below shows that banks fail because they take risks with
depositors' and other lenders' money and these risks and the resulting
losses have little to do with equity shortage.

Fractional-reserve banking: 700 years of repeated
failures

Although some forms of
fractional-reserve banking
prevailed even before the Middle Ages, reliable records of bank failures are
available since 12th-century Europe.

In 1345,
Florence's world biggest international bank (owned by the
Bardi and
Peruzzi companies)
failed after 30 years of extensive credit extension and fictitious
financial practices, resulting in a global financial collapse.

2016-2017: In December 2016, the
government of Italy approved a taxpayer bailout of Italy's largest and
oldest bank
Monte dei Paschi di Siena. This would be the third time the bank is
rescued using taxpayers' money.
Paradoxically, Monte dei Paschi purchased consulting services from
JPMorgan
Chase that in 2008 was also rescued with billions of dollars of
taxpayer money. In July 2017 the
Italian government took control of this bank.

Taxpayer subsidies provided to banks and social
costs

The big puzzle

maintain 10% reserves on
transaction accounts, and 1% on savings accounts, and

the FDIC fund is
insufficient to bail out any of the 24 largest banks in the U.S.

Then,
how can it happen that...

we still keep our money in
the bank?

banks report making profits?
and

senior bank managers collect
millions of dollars in bonuses?

This
complicated question has a simple answer: Banks rely on taxpayer-funded implicit and explicit
unconditional guarantees to
bail them out.

Banks all over the
world operate under the self-fulfilling expectation that governments do not
have the political strength to leave depositors without money after their bank
fails to return their money. In addition, banks rely on low-cost services
provided by central banks only to banks.

What kinds of subsidy?

Explicit and
implicit public subsides provided exclusively to banks include:

Ability to
open accounts and safekeeping with central banks. Currently, banks in
the U.S. are paid 0.25% interest on reserves kept with the Federal
Reserve.

Access to low-cost
money transfer services, such as the automated clearing house (ACH) and
FedWire (a real-time-gross settlement network).

Access to discount
windows providing low-cost loans to banks under the "lender-of-last-resort"
paradigm.

Implicit guarantees
to bail out failing banks under the "too-big-to-fail" paradigm.

Noss and Sowerbutts (2012)
explain how the implicit subsidy arises and why it remains a public policy
concern. Taxpayer-provided subsidies of banks generate three types of
distortion:

Banks that
most benefit from subsidies (large banks) enjoy a competitive
advantage over those that do not. This is because creditors of these
banks settle for lower interest they charge banks for bearing their
risk, thereby lowering the banks' cost of funding.

Taxpayer
guarantees increase banks' incentive to take risks as losses will
eventually be borne by taxpayers. The resulting cost to society of
financial crises could far exceed the cost of the subsidy.

Taxpayer
guarantees of banks result in an increase in the size of the financial
sector thereby diverting resources from more productive sectors of the
economy.

Empirical
estimations of the subsidies

Implicit subsidies of banks
are hard to quantify because they are not recorded or published by
governments. In fact, most taxpayers are not even aware of the subsidies
they provide to banks. Therefore, the measurements of bank activities must
first be extracted from hard data and only then be put into models that
yield estimates of the monetary value of these subsidies.

Noss and Sowerbutts (2012)
describe the different approaches used in the literature in order to
estimate implicit subsidies. The two main approaches are:

Funding advantage models
that determine the value of the subsidy as the aggregate reduction in the
cost of bank funding due to an implicit government guarantee. Cost of
funding includes interest paid to creditors.

Contingent claims models
that value the subsidy as the expected payment from the government to the
banking sector to prevent defaults and failures.

Focusing only on the banks'
cost of funding advantage aspect of the government subsidy, Acharya et al. (2015) show that the dollar
value of the annual implicit subsidy accruing to major U.S. financial
institutions amounts to on average $30 billion per year and rose above $70
billion during the recent financial crisis.

Moreover,
Marques et al. (2013) provide
international evidence on government support and risk-taking in the banking
sector. They show that the provision of explicit and implicit government
guarantees affects the willingness of banks to take risks by reducing
market discipline. More precisely, they find that more government support is
associated with more risk-taking by banks, especially during the recent
financial crisis (2009-2010).

Taxpayer and central bank direct subsidies during banking
crises

So far, we have described how governments (taxpayers)
subsidize banks on a daily basis by providing explicit and implicit
guarantees to bail out failing banks. However, taxpayers bear additional
costs during financial crises when governments actually transfer money to
banks so that banks could meet their obligations to creditors and
depositors.

So how much it costs
taxpayers to bail out failing banks? According to
Curry and Shibut (2000), during the
savings and loan crisis (S&L), 296 financial institutions with total
assets of $125 billion were either closed or rescued from 1986 to 1989. In
1989, 747 additional thrifts with $394 billion were resolved. The S&L crisis
had cost taxpayers $124 billion and the thrift industry another $29 billion.

The direct taxpayer cost
of the most recent 2008 crisis exceeded $700 billion. In addition, the
cumulative bailout commitment (asset purchases plus lending by the Federal
Reserve) during 2007-2009 was $7.77 trillion (Bloomberg) and over $29
trillion according to Felkerson (2011). Initially, the Fed tried to conceal this information from the
public, but later on was forced to release it after Bloomberg
sued.

Oxera (2011), provides an estimation of the
average taxpayer subsidy of U.K. banks in the years following the recent
banking crisis. The average state support in 2009 for the top 5 U.K. banks
exceeded £100 billion, with the average per bank being around £26 billion.
This is in addition to the £56 the banks received in 2008.

In December 2016, the
government of Italy approved a
€20 billion taxpayer finance of Italy's
largest and oldest bank,
Monte dei Paschi di Siena. This is in addition to the
€3.9 billion received in 2013. Italy's taxpayers were already exposed to
debt levels of 133% of GDP even before this bailout (second-highest in
Europe). In July 2017, the Italian government took control of this bank
after injecting
additional €5.6 billion of taxpayer money.

Social costs of banking
crises

The
implicit and explicit subsidies of banks constitute a small fraction of the
social cost
of a financial crisis. In a cross-country analysis,
Hoggarth et al. (2002) estimate the cost
of banking crises to be between 15% to 20% of an annual GDP.
Atkinson et al. (2013) estimate the social cost of the 2007–2009
financial crisis to be between 40% to 90% of one year's output ($6 trillion
to $14 trillion, which translates to $50,000 to $120,000 for every U.S.
household).

Epstein and Montecino (2016) estimate social costs by analyzing three
components: (a) rents, or excess profits; (b) misallocation costs, or the
price of diverting resources away from non-financial activities; and (c)
crisis costs, meaning the cost of the 2008 financial crisis. Adding these
together, they estimate that the financial system will impose an excess
cost of as much as $22.7 trillion between 1990 and 2023, making finance in
its current form a net drag on the American economy.

Do we need more regulations?

No, we don't. We
need much less regulations!

As also argued in
Kay (2010), bank regulations consistently
failed to protect taxpayers from having to bail failed banks. And this is
for the following three reasons:

1. Lobbying:
The graph below (source)
reveals that commercial banks spend over $1 million a week on lobbying activities.

Even if Congress
manages to pass laws that limit banks' risk-taking activities, as we show
here, often, the key components of these laws are eventually repealed by Congress
itself after banks intensify their lobbying activities.

2.
Regulatory capture: Regulatory agencies have
no incentives to enforce the
regulations. In fact, Griffin (2010)
examines the history of the Fed and its role as a protector of the
interests of large banks.
Jacobs and King (2016)
argue that the Federal Reserve managed to overstep the U.S. constitution by giving
trillions of dollars in loans to financial institutions. Their book argues
that although the 1913 Federal Reserve Act made the Fed independent of political
pressure, it actually made the Fed totally dependent on the financial
sector that it supposed to regulate. The drawback of this
dependence is not only favoritism to financial institutions and the
associated revolving
doors, but that it gave the Fed total immunity from the checks-and-balances democratic
system and transparency. More recently,
Haedtler et al. (2016) argued that the Fed should become fully public
in order to represent the diversity of public interests instead of just
the financial sector.

3. Regulatory
cost:
Kupiec (2014) reports that the average employee compensation at the
federal bank regulatory agencies is more than 2.7 times that of
private-sector bank employees. Taxpayers eventually pay the bills.
Simply put, regulations are expensive!

This widely publicized
international committee suggests regulatory guidelines on the minimum amount
of capital banks should hold. Currently, the committee recommends a minimum
Tier 1 capital ratio of 6%. To get an idea why 6% does not protect banks
against failures, compare 6% with Admati and Hellwig (2014) who argue
that banks should be at least 30% equity financed.

After the vast collapse
of banks in 1929, this Act gave each bank one year to decide whether it
would be a commercial bank or an investment bank. Commercial banks were
prevented from dealing with non-government securities for their customers
and for themselves. The intent behind this separation was to restrict
banks from speculating with depositors' money.

Over the years, the effectiveness of this law has
diminished by actual repeals of several sections of the law, by court
rulings, and by regulatory agencies that adopted weaker interpretations of the
requirements intended to separate investment banking from deposit-taking
banks. For example, already in the 1960s, First National City (today Citibank) has managed to bypass this law by introducing "negotiable CDs" that
were traded on a secondary market which blurred the difference between
deposit-taking and investment banking, see
Foroohar (2016, p.46).

Finally, in 1999, during the Clinton Administration, the Gramm-Leach-Biley Act removed the remaining
obstacles by allowing bank subsidiaries and bank holding companies to deal
with securities. Only nine years later, in
2008, large banks sought government assistance to relieve them from a
variety of "bad" securities including
credit default swaps,
subprime lending, and
collateralized debit obligations that lost their value in a short
period of time.

Also known as "The
Wall Street Reform and Consumer Protection Act," it was signed into law on July
21, 2010, and represents the latest failed attempt to regulate banks in
order to reduce their dependence on taxpayer money after the 2008 financial
crisis.

Less than 5 years after the
law was signed by President Obama, intensive
lobbying activities of the banks led Congress to pass a
Spending Bill that rolled back a rule which restricted trade in derivatives,
the very financial product that helped to cause the financial crisis of
2008. This bill also removed the restrictions on the use of government
money to bail out failed banks.

But, I have read in the
newspaper that central banks are now taking some actions

Here is the story: On November 9,
2015, the Financial Stability Board (FSB)
has issued new
guidelines on bank balance-sheets that require banks to increase
their
capital ratio to 16% by 2019 and to 18% by 2022. What's odd about
these guidelines is that they totally ignore the fact that major banks
that failed in 1929 held over 20% equity on their balance sheets, see
Foroohar (2016, p.33). Banks do not
fail because of lack of capital but because they take risks with
depositors' money and the type of securities they trade with.

Capital ratio consists of
mostly equity (value to shareholders) plus cash reserves
all divided by the assets of the bank. But now, instead of calling it just
capital, the regulators apply some marketing techniques and call it "Total
Loss Absorbing Capacity" (TLAC),
perhaps to create an impression that the taxpayer will be off the hook in
future crises.

So, should we expect
banks to stop failing after 2019? Wishful thinking! Even if banks will
eventually comply with the TLAC requirement, the next collapse of the banking
sector will require the taxpayer to be responsible for the remaining 82%
of the losses (less cash reserves that banks may hold). But, these loses
could be much higher because of
fire sales
that would further diminish the value of banks' capital during the next crisis.

More regulations versus
structural change

So, if banks cannot be
regulated, what else can be done? The narrow banking proposal calls for a
structural change of the banking industry. Financial institutions would be
split into two types:

1. "Narrow" banks
where depositors are backed by 100% reserves held at central banks. Part
of the interest paid by the central banks could be passed on to depositors
who can use these accounts as a safe savings option.

2. Risky banks and mutual
funds that may fail from time to time, where depositors (not taxpayers)
would bear all the risk. Mutual funds have the advantage that they are more
transparent than banks, but this may change over time as a result of
competition.

History of the narrow
banking proposal

The proposal
that depository institutions maintain 100% reserves goes back to the Great
Depression and is attributed to a group economists at the University of
Chicago. In 1933 this group wrote a memo
(signed by
Frank Knight) to
Henry
Wallace who then sent a
letter to President Roosevelt. The memo describes the plan for how to
guarantee bank deposits by requiring banks to maintain 100% reserves as well
as the separation of the "Deposit and Lending functions of existing
commercial banks." [p.3].

According to
Hart (1935),
the proposal called for "the radical reform of the American banking system
by requiring reserves of 100 percent against all deposits..." and had some
support in the political world.

Friedman (1959,
Ch. 3) adopted the Chicago plan and went even further by suggesting that
interest be paid on the 100% reserves (by the Fed, or from a special budget
allocated by the Treasury). According to Friedman, if the banking industry
is competitive, this interest would also benefit depositors as some of the
interest would pass-through on to depositors and therefore encourage savings.
It would also compensate banks for their loss of revenue from having to
reduce or terminate their lending activities.

In June 1934,
bills were introduced in both
houses of Congress requiring the "maintenance of 100 percent reserve against chequing deposits." In other words, the plans called for a total separation
of the credit functions of banks from deposit-taking related services, so that all
deposits would be 100% backed by government-issued money. According to
Benes and
Kumhof (2012), the
Chicago Plan was never adopted as law due to strong resistance from the
banking industry.

"I have come to believe that the plan, properly worked out and applied, is
incomparably the best proposal ever offered for speedily and permanently
solving the problem of depressions; for it would remove the chief cause of
both booms and depressions, namely the instability of demand deposits, tied
as they are now, to bank loans."

On page 15, Fisher writes:
"This means that in practice each commercial bank would be split into two
departments, one a warehouse for money, the checking department, and the
other the money lending department, virtually a savings bank or investment
bank."

Common critique of
narrow banking

Critics of the narrow
banking proposal point out that narrow banking will not fix the
financial sector because loans will be pushed into
shadow banking which is harder to regulate.

This line of criticism is partially correct, but misses the point: Narrow banking
has only one purpose: To eliminate fractional-reserve banking that has
never worked and always relied on taxpayer money. By separating deposits
from lending and any other financial instruments, government may finally possess the political power
they need to refuse to bailout financial
institutions because depositors' money will be then backed by 100% reserves.

A second common critique
of narrow banking is that the abolition of fractional-reserve banking will
increase lending rates. Fractional-reserve banks are able to charge low
rates because of the implicit and explicit taxpayer
subsidy of banks. In fact, borrowing
from banks is almost equivalent to borrowing from the government because
governments don't let banks fail. That is, the lending market is
already destroyed by not creating true competition among lenders that
would not favor banks. Mutual funds and peer-to-peer lending would
generate market-determined optimal lending rates, which could be
higher than the ongoing rates.

Both critiques may be
dismissed if all lending is shifted to mutual funds.
Mutual funds in general and
index funds in particular, allow investors (savers) to diversity their
risk with mixed transparent portfolios. For example, mutual or a
pension funds that invest 40% in treasury bonds, 25% in stocks, 25% in
corporate bonds, and 10% in mortgages impose low risks on savers and are unlikely to be bailed out using taxpayer money.

Structure and history of fractional-reserve
banking

Definition
of "fractional reserve"

Commercial
banks are often referred to as "fractional-reserve"
depository institutions. The reason behind this terminology is that banks
actually keep only a small fraction of depositors' money in the form of
cash or in deposits held safely in the central bank. Therefore, most
commercial banks are not able to meet the demand for cash withdrawals
unless the withdrawals are made by a small fraction of account holders.

Moreover,
fractional-reserve banks "bundle" risk with deposits by taking risks with
depositors' money without obtaining any permission from depositors, Shy
and Stenbacka (2000,
2008). This is not the
case when people deposit money with mutual funds where they can choose the
exact risk portfolio that meets their preference.

Banks' money creation: The textbook story

Most college
textbooks on money and banking describe a model showing how
fractional-reserve banks create money. The reader should bear in mind that
even if the model were true, there has not been any research that managed
to provide any social welfare justification for money creation by
commercial banks.

Consider an
economy where banks maintain 10% reserve ratios. A person with $100
deposits the money with bank A. Bank A then lends $90 to another person,
who then deposits it in Bank B. Bank B lends 0.9 x $90 = $81 to a person
who deposits it in Bank C. Total money created in the economy can be
computed to be:

Therefore,
according to this textbook scenario, the banking system has created
additional $900 of inside money from an initial $100 deposit. As we show
below, taxpayers incur an additional loss of revenue
(seigniorage) from letting commercial banks create money instead of the
government or the central bank.

A logical problem with the standard explanation

A Bank of
England working paper, McLeay et al.
(2014), identifies a logical problem with the standard explanation of
money creation, namely, that this explanation neglects to mention
where the initial $100 came from.

The answer is that the
person has probably received the initial $100 from her employer. But the employer
had to get the $100 from somewhere, which means that the employer withdrew
$100 from the business bank account. Therefore, the total net initial change in the
money supply should be zero and not $100.

The main conclusion of
that paper is that, contrary to the standard textbook assertion that
"deposits create loans," the correct assertion should be that "loans
create deposits." This means that, under the revised model, banks create
even more money during economic booms, and contract faster during
recessions, which explains why banks' money creation amplifies the
business cycle.

The authors demonstrate
their explanation with the following aggregate balance sheet of all
commercial banks.

As the figure shows,
new money and deposits are created at the moment the bank grants a loan to
a customer. This type of deposit is often referred to as "fountain pen
money" created at the stroke of a banker pen when a bank approves a loan. The
former governor of the Bank of England
King (2016) calls this process money "alchemy"
(creating money from thin air).

Fractional-reserve banking emerged in Europe during the Middle Ages by
money changers. Whereas the use of coins by money changers
has been a great improvement
over barter trade by reducing the problem of
double coincidence of wants, it
was hard to maintain uniform quality of coins to represent
a given unit of account.

Consequently,
Middle Ages money changers quickly realized that they can open accounts and
settle local transactions without the need of always giving and receiving
metal coins. Because coins were needed only when depositors withdrew them,
money changers began allowing some customers to overdraft their accounts. By
doing so, money changers turned into fractional-reserve banks that we
observe until this very day.

From the Middle
Ages to this very day, depository institutions continued the practice of
lending out depositors' money, thereby creating new money via the
money
multiplier. In addition, they create their own money.

The failure of reserve requirements

According to
Feinman (1993), recognizing banks’
strong incentives to lend, some states in the United States began requiring
banks to maintain some reserves on deposits.

Reserve requirements were
first established at the national level in 1863 with the passage of the
National Bank Act, where banks had to hold a 25% reserve against both notes
and deposits—a much higher requirement than that faced by most state banks.
Reserve requirements were seen as necessary for ensuring the liquidity of
national bank notes and thereby reinforcing their acceptability as a medium
of exchange throughout the country. In 1864, the required ratio was lowered
to 15%.

As of January 2015, the
ongoing required reserve ratios (determined by the Board of Governors
of the Federal Reserve) are: 10% for depository institutions with net
transaction accounts exceeding $103.6 million, 3% for depository
institutions between $14.5 and $103.6 million, and none for depository
institutions with less than that.

During financial
crises, banks often argue that they fail because the economy failed. In
2008 the economy did not fail. It is the financial sector that always fail
first and drags the economy with it.

Has anything changed since
the Middle Ages?

Not really, since the Middle
Ages, banks continued to lend money they mostly don't have. Technology may
have changed, but the incentive to maximize the amount of lending has not
vanished, and actually became stronger with the introduction of new
financial instruments, such as
subprime mortgages.

But, wait a minute, one
thing did change over the years. We now have venture capital and a huge
market for
mutual funds. that did not exist in the Middle Ages. The mutual funds
market in the U.S. has
8,000 funds (and growing) with total assets exceeding $15 trillion.
Worldwide mutual fund assets now exceed $31 trillion.

The large variety of funds
reflect different degrees of risk, diversification, and liquidity that
savers can choose from. A large portion of these funds lend money just as
banks, with the difference that mutual funds lend money they have whereas
banks lend money they mostly don't have.

Perhaps the most important
feature of mutual funds is that they are
transparent. Each mutual fund lists its entire portfolio on the Internet so
savers can switch funds whenever they want to. In contrast, banks do not tell
depositors where their money goes, so depositors do not have any control
over their risk.

The lack of transparency of
how banks handle their depositors' money and the money they create with it
reduce governments' political strength needed for refusing to bail out failing
banks, because politicians will argue that depositors cannot be "punished"
for risks they did not take.

Summary: Reasons for
failure and non-optimality of the system

This fractional-reserve
banking system has fails for the following reasons:
(a) Banks frequently fail to fulfill their obligations to depositors
unless supported by government money.
(b) Banks Rely on taxpayer money before they fail (implicit subsidies) and
after they fail (explicit taxpayer subsidies).
(c) Banks bundle risk with account safekeeping and payment services. That
is, banks expose depositors' money to risk without obtaining permission to
do so (in contrast to mutual funds where investors can control and monitor
risk taken with their money.

Can bank failures be
compared with fires and car accidents?

Despite the 700+ years
of bank failures, currently, the overwhelming majority of economists,
policy makers, and bankers (of course) favor fractional-reserve banking
over any other financial system. The most common defense of the system is
the story of "fire." Although most (not all!) proponents of
fractional-reserve banking do acknowledge the repeated bank failures, they
tend to compare bank failures to fires and car accidents by making the
following arguments: "The fact that banks fail does not imply that the
system needs to be changed because the fact that we observe fires does not imply that people should not live in
houses." Similarly, "the fact that there are car accidents does not imply
that cars should be prohibited to drive."

Do these arguments make sense? Not really, because most house owners try to
avoid fires and most car owners try to protect their cars to avoid any
accident. In fact, insurance companies place high deductibles precisely
for this reason. In contrast, bank managers who make the decisions how
much risk to take with depositors' money are not the owners of this money.
That is, banks earn profit by taking risks with money that they do not
own. Moreover, taxpayer protection of bank failures does not place any
deductibles with respect to managerial compensation. In each financial
crisis, bank managers receive golden parachute compensations and move on to
other businesses. Putting it more formally, fractional-reserve banking
tends to bundle risk with deposits without the knowledge and consent of
depositors who own this money. This cannot be compared to house or car
owners who themselves make all the risk decisions associated with their
own property and also bear the consequences associated with their
own failures.

Past and ongoing attempts to implement narrow
banking

First known
implementation of narrow banking

Bills
submitted to Congress but failed to pass

In June 1934, with
the knowledge of President Roosevelt, bills were introduced in both houses
of Congress requiring the "maintenance of 100 percent reserve against
chequing deposits." Senator Bronson Cutting introduced it in the Senate on
June 6th, 1934 (S. 3744). Congressman Wright Patman introduced it in the
House (H.R. 9855). Eventually, under pressure from banks, these two bills
failed to pass.

More-recent proposals

Johnsen (2014) describes the collapse
of Iceland's three largest banks in 2008 that caused the worst loss relative
to GDP than in any other country. It is therefore less surprising the
Iceland's prime minister found the political strength to commission a report on
the possibility of moving Iceland to a narrow banking system,
Sigurjónsson (2015).

The report finds that to
accommodate their lending activities, banks expanded the money supply
nineteen fold between 1994 and 2008. The report argues that banks' lending
activities tend to amplify the economic cycle (expansion during boom time
and contraction during downturns). In addition, the government guarantee of
bank deposits gives banks an unfair competitive advantage over other
non-guaranteed financial institutions.

Huber and Robertson (2000) and
Dyson et al. (2014) propose taking away
banks' ability to create money and let central banks gain full control over
the money
supply. This will enhance stability reduce economic fluctuations.
Another advantage would be that
governments (not banks) will be able to collect the
seigniorage
revenue associated with money creation.

The most recent attempt
to eliminate fractional-reserve banking is currently taking place in the
"land of banking:" Switzerland. In 2016 the Swiss government was supposed
to hold a
referendum on the
Vollgeld Initiative that would require private banks to hold 100%
reserves against their deposits.

The transition period

A complete switch to narrow
banking would eliminate "money creation" by banks as banks will maintain
100% reserves mostly held in the central bank. This
raises the question how money that has already been created by banks would
be eliminated during the transition period.

Amazingly, the originators of
the narrow banking proposal were aware of this potential problem.
Fisher (1936) explicitly addressed
this issue by proposing that money created by banks would be turned into
government loans to banks, until banks manage to collect all the money they
loaned out.

A less ambitious transition
period could start by providing incentives and benefits to new financial
institutions that maintain 100% (such as payments service providers to be
discussed below). The coexistence of 100% liquid banks with the traditional
fractional-reserve banks would be possible if central banks pay
sufficiently high interest on reserves (some of which could be passed on to
depositors), see Tobin (1985).

The digital revolution

Financial technology (FinTech)
is an emerging industry with startup companies that develop software for the
purpose of disrupting the traditional banking sector. The book by
McMillan (2014) predicts that the
digital revolution will bring the banking era to an end.

The Bank for International
Settlements analyzes the
presence of non-banks in all stages of the payment process and across
different payment instruments. These services are
widely used by all sorts of consumers, including those who do not have bank
accounts. Owners of general-purpose reloadable (GPR)
prepaid cards who do not have checking accounts comprise
4.8% of U.S. adults.

Policy recommendations and FinTech

Is there
any hope for a change?

Just like the
failed attempts during 1930s, it seems unlikely that narrow banking will be
implemented in the near future because of strong resistance from the
financial sector, sharp disagreements among academic economists as to whether
narrow banking is the cure, strong lobbying, and lack of motivation on the regulator side.

Is this the end?
Not yet! Ongoing and emerging technologies (FinTech) are on the narrow
banking side of this debate.

Have no
direct access to low-cost settlement services provided by central
banks, and therefore must settle their transactions via the
banks.

Policy options to promote
efficiency

To overcome this obstacle
and to encourage competition with established banks, it has been proposed
that non-bank payment service providers would be allowed access to the same
services that banks currently receive from central banks, see for example Bank of England (2015,
pp.7–8). The United States
OCC is now
considering granting
"Fintech charter" applications to become special purpose national
banks.

Allowing non-banks to open accounts with central banks
would remove a major obstacle faced by non-banks. Because the transactions performed via
these service providers are prefunded, they actually behave as
narrow banks that maintain 100% reserves and pose no risk on the system.

The advantages of moving to
such an industry structure include:

Risk reduction: All
payments are prefunded and stored in central banks.

Newer technologies
(real-time payments) at a fraction of the cost.

Gradual shift of depositors
from fractional-reserve banks to institutions that maintain 100% reserves.

But, what about the
lending side?

A common criticism of
the narrow banking proposal is that it neglects to reform the lending side
of banks. The critics argue that narrow banking will push more lending
activities into
shadow banks that are also risky and less regulated.

However, this criticism
neglects to consider the fact that lending could be easily managed
by mutual funds. As mentioned above, the mutual funds market in the U.S.
has over
8,000 funds with total assets exceeding $15 trillion.
Worldwide mutual fund assets now exceed $31 trillion. Funds such as
those that diversify between stocks and bonds could add 10%–30% mortgages
and other household loans into their portfolios. Investors and pension
funds should be able to select the funds that match their risk versus return
goals.

The advantages of
shifting lending activities from fractional-reserve banks to mutual funds
include:

Lenders (investors) will
be able to choose the degree of risk associated with lending activities.
Currently, under fractional-reserve banking, banks bundle risk with
deposit safe-keeping without asking depositors what degree of risk (if
any) they prefer, Shy and Stenbacka (2000,
2008).

Increase transparency.
Mutual funds list their portfolios on the Internet. In contract, banks do
not report what they do with depositors' money.

Reduce or eliminate debt
from the economy because loans become transfer of existing funds (as
opposed to money creation by banks),
Kotlikoff (2010).

Eliminate taxpayer
responsibility from having to bailout banks when borrowers default on
their loans.

Finally, note that FinTech
is already active in the lending dimension as well. Companies such as
LendingClub (now public),
Prosper,
Lend Academy, and
CommonBond, facilitate peer-to-peer lending without having to create any new money.

Other distortions associated with the current financial
system

(a) Expansion of
the banking sector crowds-out real investment

"...we
are throwing more and more of our resources, including the cream of our
youth, into financial activities remote from the production of goods and
services, into activities that generate high private rewards
disproportionate to their social productivity."
James Tobin,
1981 Nobel Prize laureate, (1984, p.14).

Perhaps the real danger
of the fractional-reserve system is that it can grow with no bounds. The
table below (King, p.95) exhibits the
alarming growth in the
ratio of bank assets to annual GDP.

U.S.

U.K.

Change in 100 years

20% to 100%

50% to 500%

Top 10 banks today

60%

450%

By 2007, this ratio has
reached 800% in Iceland. What fractional-reserve banks do is to increase
their asset side with all kinds of financial instruments (CDO,
MBS,
CDS)
that have nothing to do with deposit taking. Moreover, bank holding
companies are not prohibited until this very day from trading and owning
commodious such as aluminum and crude oil, see
Omarova (2013). Once these assets lose
their value, it is hard to figure out what banks did with depositors'
money, and governments use taxpayer money to recover the lost funds. With
narrow banks, the size of the assets equals exactly the amount of deposits
held by banks.

As noted in
Kay (2015), since the 1960s, a larger
fraction of college graduates in general, and engineering schools in
particular, accepts jobs outside their field to become investment bankers
or management consultants.
Shy and Stenbacka (2017b) construct an overlapping-generations model
to demonstrate how bank money creation diverts resources from
productive activities.

Apart from the
crowding-out of human capital (misallocation of skilled labor), Cecchetti
and Kharroubi (2012,
2015) show
theoretically as well as empirically that financial sector growth
disproportionally benefits sectors with low productivity and high
collaterals, thereby reducing total factor productivity growth in the
economy as shown in the following graph:

The graph shows that
per-worker GDP growth can decline with an increase in a country's share
of employment in the financial sector (deviation above the country's
mean). Similar inverted U-shaped results are also estimated in
Arcand,
Berkes, and Panizza (2015), where the financial sector has negative
effects on growth when the credit to the private sector reaches 80-100% of
GDP. The following graph, taken from an IMF study,
Barajas et al. (2015),
estimates that if the financial sector were the proper size, the U.S.
economy would be enjoying a normal economic recovery of 3% to 4% per year
instead of the dismal 1% to 2%.

Epstein and
Montecino (2016) measure the excess social cost of large financial
sectors by adding three components: (a) rents, or excess profits; (b)
misallocation costs, or the price of diverting resources away from real
investments; and (c) crisis costs, meaning the cost of the 2008 financial
crisis. They estimate that the financial system will impose an excess cost
of as much as $22.7 trillion between 1990 and 2023, making finance in its
current form a net drag on the American economy.

(b) Government loss of
seigniorage revenue

Taxpayers incur an
additional loss of revenue from letting commercial banks create money (see
above) instead of the government or the
central banks. The profit generated from the creation of money is called
seigniorage, which is defined as the difference between the cost of
physically producing money and its purchasing power in the economy. For
example, if a $10 note costs 20 cents to produce, seigniorage profit to
the issuer of this note is $9.80. A
2017 report computed the seigniorage taxpayer loss of revenue at the
aggregate national level of selected countries to be:

That is,
British taxpayers lose 1.23% of their GDP to commercial banks. The narrow
banking proposal provides an immediate solution to this revenue loss by
leaving money creation to the central banks and by requiring banks to
maintain 100% reserves.

Entertainment and fractional-reserve banks

"Mary Poppins"
banks

There may be no
better place to learn about the structural weakness of the current banking
system than from watching the 1964 Disney classic movie entitled
Mary Poppins.
Dick Van Dyke, portraying a chairman of a bank who is a "giant in the world
of finance," tries to convince the kids to hand him their tuppence for the
purpose of opening a bank account. He sings:

If you invest
your tuppence
Wisely in the bank
Safe and sound
Soon that tuppence,
Safely invested in the bank,
Will compound,

And you'll achieve that
sense of conquest
As your affluence expands
In the hands of the directors
Who invest as propriety demands.

You see, Michael, you'll be part of
Railways through Africa
Dams across the Nile
Fleets of ocean greyhounds
Majestic, self-amortizing canals
Plantations of ripening tea.

The old chairman ends his lecture by stating that "where
stands the bank of England, England stands, and when falls the bank of
England, England falls!" Eventually, the kids refuse to deposit their
tuppence and create a panic leading to a
run on the bank, so the kids'
expectations become
self-fulfilling.

The Long
Johns

In
8
minutes you will learn about everything you felt ashamed to admit that
you don't understand. Terms like: Subprime market, investment
vehicles, structured high-grade funds, and investment banking.
and how the financial sector obtains money from the government during
banking crises.

Contact Information

Comments and suggestions should
be sent to:
info@narrowbanking.org
The purpose of this site is to stimulate discussions and research on how to
reform the banking system
The site is currently maintained
by Oz Shy. This site first
went live on June 11, 2015 (Last update, July 27, 2017)
The URLs directed to this site are:
www.BankingReform.org and
www.NarrowBanking.org